Exclusively from Michael Pettis newsletter:
I am, perhaps uncharacteristically, a lot more confident than many others that the PBoC will manage to meet its target deadline to liberalize the deposit cap. I think their timing makes complete sense and is in fact what I have been expecting. Remember that the best measure of the extent of financial repression is the gap between the nominal GDP growth rate – which in recent years has fallen from above 18% to below 10% – and the nominal lending rate. At this point the gap is probably around 200 basis points, far lower than the 1000 basis points or more most of this century.
The gap should close further as long as the PBoC can resist pressure to lower the lending rate. Because I expect growth rates will continue to drop sharply in the next two years, and I think we are more likely to experience near-term disinflation rather than inflation, by 2016 it is very possible that nominal GDP will be around or below 8%. When this happens I would suggest two things:
Financial repression will have been largely eliminated from the system. The PBoC can remove all interest rate caps and interest rates should barely budge.
Of course this doesn’t mean that we won’t have the financial distress problems associated with surging interest rates. We will, but they will occur in the form of declining nominal GDP growth rather than soaring nominal interest rates. Large inefficient borrowers, in other words, and this includes many if not most SOEs, will suffer from high interest rates, but the suffering will not occur because debt-servicing costs have risen but rather because debt-servicing capacity will have declined. Borrowers will no longer be able to depend on high growth in nominal GDP to bail them out. Slowing growth and disinflation will allow the PBoC to accomplish the difficult task of eliminating the distortions caused by financial repression without seeming to do anything, but it will still be painful and will weigh heavily on SOE profits.
…Liberalizing interest rates is probably the single most important step China can take to eliminate the distortions in the Chinese economy – far more important than any change in the currency regime, for example – but there is no way that it will not be painful.
Much of the debate in China now revolves around how much growth we can expect this year. The good news is that even those most determined over the years to argue that there is no reason for China to slow down have now acknowledged that there is almost no chance that it will not. I was told by some of my students who attended the INET conference in Hong Kong last year that one of China’s most prominent economists spent his entire speech explaining why my prediction that China will grow by an average of 3-4% over the 2012-22 period (actually I have always said that this is the upper limit of growth) was impossible, and why growth would average well above 7% during this period.
…How can GDP grow at 3% while household income grows at 5%? It seems difficult but in fact is not at all impossible. Remember that during Japan’s rebalancing period, from 1990 to 2010, GDP grew by ½% but household income grew by nearly 2%. For this to happen all we are saying is that the household share of GDP, after contracting for thirty years, must now rise while the state share contracts.
Or, to put it another way, instead of boosting investment growth by transferring wealth from the household sector to the state sector, we must now boost consumption by transferring wealth from the state sector to the household sector. This is all the Third Plenum reforms do, but it is why the adjustment will be so politically difficult and why there will be so much opposition from the vested interests.
